What Do We Know About Market Discipline in Insurance?

• Author: Martin Eling
• Date: 01 September 2012
• Published date: 01 September 2012
• DOI: http://doi.org/10.1111/j.1540-6296.2012.01217.x

Risk Management and Insurance Review

C

Risk Management and Insurance Review, 2012, Vol.15, No. 2, 185-223

DOI: 10.1111/j.1540-6296.2012.01217.x

PERSPECTIVES

WHAT DOWEKNOW ABOUT MARKET DISCIPLINE IN

INSURANCE?

Martin Eling

ABSTRACT

The aim of this article is to summarize the knowledge on market discipline in in-

surance and other financial service sectors. Market discipline can be defined as

the ability of customers, investors, intermediaries (agents, brokers), and evalu-

ators (analysts, auditors, rating agencies) to monitor and influence a company’s

management. Looking at banking is especially interesting, since market disci-

pline in this field has been studied extensively. Based on existing knowledge,

we develop a framework for researching market discipline in insurance that

includes its most important drivers and impediments. The results highlight a

significant need for continuing research. The findings are of relevance not only

for European insurers and regulators, but for institutions outside Europe.

INTRODUCTION

An important new dimension of the regulatory environment in banking and insurance

is explicit reliance on market discipline. Market discipline—the influence of customers,

investors, intermediaries (e.g., agents), and evaluators (e.g., rating agencies) on firm

behavior—is a central element of both Basel II and Solvency II. Market discipline has

been a perennial topic of research in the financial services sector since the 1970s (see

Flannery, 2001). Likely due to the fact that Basel II has been in force for several years,

most research into market discipline’s ability to regulate financial services has focused

on banking (see, e.g., Martinez Peria and Schmukler,2001; King, 2008), but some research

has also been conducted for the insurance sector.1Solvency II should add even more

The author is Professor of Insurance Management and Director of the Institute of Insurance

Economics at the University of St. Gallen, Kirchlistrasse 2, 9010 St. Gallen, Switzerland; e-mail:

martin.eling@unisg.ch. The author is grateful to Christian Biener, Dieter Kiesenbauer, Sebastian

Marek, and Jan-Philipp Schmidt for helpful comments and suggestions. Special thanks to Peter

Schlosser for his excellent researchassistance. This article was subject to double-blind peer review.

1Related articles, such as Harrington (2004, 2005) and Nocera (2005), will be discussed in detail

throughout this article. Another excellent introduction to market discipline in the German

language is Hartung (2005). Furthermore, Solvency II’s approaching effective date has resulted

in several recent empirical studies on market discipline in insurance (e.g., Eling and Schmit,

Forthcoming). Also, experimental evidence from behavioral insurance (Wakker et al., 1997;

Albrecht and Maurer, 2000; Zimmer et al., 2009) is relevantfor market discipline. Furthermore,

the European Commission conducted research when designing Solvency II (see CEIOPS, 2009,

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186 RISK MANAGEMENT AND INSURANCE REVIEW

impetus to the study of market discipline. It is thus important to consider what is already

known about market discipline in the insurance and related sectors.

Tothat end, this article summarizes extant knowledge on market discipline in insurance

and other financial services sectors. Looking at banking is especially interesting, since

market discipline has been studied extensively in this field and much can be learned from

that work. Based on existing knowledge, we develop a framework for researchingmarket

discipline in insurance that includes its most significant drivers and impediments. Our

results also highlight a significant need for future research.

The results provide a clearer understanding of how market discipline works as a direct

and indirect mechanism for monitoring and influencing by customers,investors,interme-

diaries,andevaluators. There are significant differences between banking and insurance

with regard to market discipline. Wealso identify important differences between lines of

business and legal forms in the insurance industry, which reveal that market discipline

might be weak in some areas (e.g., in personal lines with complex products or with

mutuals) and strong in others (e.g., in commercial lines or with stocks). We thus find

a number of reasons why a “one-model-fits-all” approach might be inappropriate for

market discipline in the insurance industry.The results of this analysis will be useful for

insurers, regulators, and policymakers involved in revising regulatory standards both

in Europe and in other markets. The article is not meant as an argument in favor of any

particular type of regulation, but as an outline of potential impediments regulators may

face in their efforts to enhance market discipline.

This article is organized as follows. In the following section we review definitions and

characteristics of market discipline that highlight differences between insurance and

other financial services sectors. Then we take a look at the extant literature especially

that involving the banking field, and derive drivers of and impediments to market

discipline in insurance. Finally, we conclude with potential policy implications and a

summary of future research needs.2

DEFINITION AND MEASUREMENT OF MARKET DISCIPLINE

Definition of Market Discipline

There are several definitions of market discipline currently in use. For example, in the

banking literature, there is widespread agreement that market discipline involves two

distinct components (see Flannery, 2001; Bliss and Flannery, 2002; Forssbæck, 2009): (1)

the ability of market participants to accurately assess the condition of a firm (monitoring)

and (2) their ability to impact management action in a way that reflects that assessment

(influencing). Market discipline thus has both an indirect and direct dimension (see

Forssbæck, 2009). Monitoring captures the infomation aspect of market discipline; that

and other information on the Commission’s Internet pages). Finally, there is a long research

tradition in the field of theory of competition, which is related to this topic (see, e.g., Stigler,

1971; Joskow, 1973; Posner, 1974; Munch and Smallwood, 1981; Stiglitz, 1984).

2Throughout this work, we analyze the role of both investors and customers in market discipline,

instead of focusing on just one of these stakeholders; we also do not focus on any specific

country. It is, however, important to keep in mind that differences across countries, such as

governance mechanisms, insolvency experiences, and cultural norms, will affect the level of

market discipline.

WHAT DOWEKNOW ABOUT MARKET DISCIPLINE IN INSURANCE? 187

is, current and prospective bank claimants inform themselves about the bank’s condition

and set prices for their claims accordingly. Influence refers to the mechanism by which

banks, in order to avoid the adverse consequences of stronger discipline (such as higher

financing costs and, ultimately,liquidity problems) decrease their risk exposure or avoid

increasing it in the first place.3

In the insurance field and with regard to the first component (monitoring), intermedi-

aries (agents, brokers), evaluators (auditors, analysts, rating agencies), and regulators

assess the financial strength and service quality of insurers. Due to the postinsolvency

assessment funding mechanism of many guaranty funds and potential contagion effects

of financial problems among insurers, insurers in selected lines also have an incentive

to monitor each other (see Downs and Sommer, 1999). Overall, it thus seems that there

are enough market participants willing to monitor risk taking in insurance. Guarantee

schemes and the opaqueness of some insurers, however, could limit the willingness and

ability to observe insurer behavior (see Lee et al., 1997; Babbel and Merril, 2005; Pottier

and Sommer, 2006; Zhang et al., 2009).

The second component, influencing, is difficult to evaluate. The finance literature con-

tains numerous reasons why we should be skeptical about the ability of market partic-

ipants to influence managers (see Bliss and Flannery, 2002), including asymmetric in-

formation, costly monitoring, principal–agent problems, and conflicts of interest among

stakeholders. Another impediment to market discipline is a legal environment that

makes shareholder activism, for example, a hostile takeover, difficult. From the share-

holders’ perspective, monitoring and incentive contracts can be combined to mitigate

the agency problem, and there are also other mechanisms that may induce managers

to act in the shareholders’ best interests, such as reputational concerns, competitive

labor markets, and the threat of takeover, dismissal, or bankruptcy (see Aggarwal and

Samwick, 1999). The insurance sector has a number of characteristics that might limit the

influencing component. For example, there is a relatively small risk of a bank run, at least

in selected lines.4Furthermore, especially in personal lines, individual policyholders are

relatively small in terms of contract volume, which limits their ability to affect decisions.

It thus seems that the influencing component of insurance sector market discipline is

not without difficulties and needs more study.

While most definitions of market discipline in the banking context include the mon-

itoring and influencing components, Harrington (2004) and Nocera (2005) add an-

other interesting dimension that is especially relevant in the insurance context. They

differentiate between investor-driven market discipline, that is, financial market discipline,

3Compared to the neoclassical definition of market discipline in a complete and frictional market

with symmetric information (leading to different willingness to pay depending on the default

put option value; see Doherty and Garven, 1986), these definitions typically emphasize the

aspect of asymmetric information, which is reduced by increasing market transparency.

4In nonlife insurance, payments are linked to claim events, and insurers are funded in advance.

In life insurance, surrendering a contract has disadvantages, such as lapse costs, and thus the

policyholder has an incentive not to terminate the contract. See Eling and Schmeiser (2010).

In countries with low lapse costs and higher mobility of capital, there could be a risk of an

“insurance run,” at least in selected insurance sectors. See DeAngelo et al. (1994) with regard to

the collapse of First Executive in the United States in the early 1990s.